How to Use a Life Insurance Policy While Alive

Traditionally, life insurance provides financial protection after death. However, modern policies offer ways for policyholders to access funds during their lifetime. These options provide liquidity for various financial needs, making life insurance a dynamic asset. Understanding these mechanisms allows individuals to leverage policies for financial flexibility when circumstances arise.

Accessing Policy Cash Value

Many permanent life insurance policies, like whole life and universal life, have a cash value savings component. This cash value grows tax-deferred as premiums are allocated to it. Policyholders can access this cash value through loans, withdrawals, or by surrendering the policy.

Policyholders can borrow funds against their cash value, using it as collateral, without direct withdrawal. Interest typically accrues at 5% to 8%, which can be fixed or variable. While there’s no strict repayment schedule, any outstanding loan balance, including interest, reduces the death benefit. Policy loans are generally not considered taxable income if the policy remains in force and the loan is not defaulted upon.

Direct cash withdrawals from the cash value reduce both the policy’s cash value and its death benefit. Tax implications depend on the amount relative to the policyholder’s cost basis, which is the total amount of premiums paid into the policy. Withdrawals are generally tax-free up to the cost basis, as this is considered a return of the policyholder’s capital. Amounts exceeding the cost basis are typically taxed as ordinary income.

Another way to access the cash value is through policy surrender, which involves terminating the life insurance contract in exchange for its cash surrender value. This value is the accumulated cash value minus any surrender charges or outstanding loans. Surrender charges are fees often imposed if a policy is terminated within the first few years, typically decreasing over 10 to 15 years. Any amount received upon surrender that exceeds the cost basis is a taxable gain subject to ordinary income tax.

Utilizing Living Benefit Riders

Beyond accessing cash value, life insurance policies can offer living benefit riders, also known as accelerated death benefits. These allow policyholders to receive a portion of their death benefit while alive, typically triggered by specific health events. They provide financial support during challenging times and can be included automatically or added for a cost.

The terminal illness rider allows access to funds if a physician certifies a limited life expectancy, typically 12 to 24 months. These funds can be used for any purpose, such as medical expenses, home modifications, or income replacement.

Chronic illness riders provide benefits if the insured cannot perform a certain number of Activities of Daily Living (ADLs), usually two out of six (bathing, dressing, eating, continence, toileting, and transferring), or has severe cognitive impairment. A physician’s certification, often within the last 12 months, confirms the condition. These benefits help cover long-term care costs.

Critical illness riders are triggered by specific severe medical conditions, including cancer, heart attack, stroke, kidney failure, or major organ transplants. Payouts can be a lump sum or periodic payments, depending on policy terms. Accessing funds through any living benefit rider reduces the remaining death benefit. While generally tax-free under federal law for qualified terminal or chronic illnesses, these benefits may impact eligibility for public assistance programs like Medicaid.

Viatical and Life Settlements

Another avenue for accessing financial value from a life insurance policy during one’s lifetime is through settlements, which involve selling the policy to a third party. This sum is greater than the cash surrender value but less than the full death benefit. The buyer assumes future premium payments and receives the death benefit upon the insured’s passing.

A viatical settlement is for individuals with a terminal or chronic illness, typically with a life expectancy of 24 months or less. To be tax-exempt under the Health Insurance Portability and Accountability Act (HIPAA) of 1996, specific Internal Revenue Service (IRS) requirements must be met, often including a physician’s certification of the limited life expectancy. If these criteria are satisfied, proceeds are treated as an advance on the death benefit, which is generally not taxable.

A life settlement, in contrast, involves selling a policy by a policyholder typically aged 65 or older, or with a significant health impairment, but not terminally ill. Its tax treatment is more complex than viatical settlements. Proceeds are taxed in tiers: the portion equivalent to premiums paid (cost basis) is tax-free. Amounts received above the cost basis up to the cash surrender value are taxed as ordinary income. Proceeds exceeding the cash surrender value are taxed as capital gains.

The process for both settlements involves steps. The policyholder submits an application with medical and policy information. Buyers review this and make offers, which the policyholder can accept or decline. If an offer is accepted, policy ownership transfers to the buyer, and the cash payment is disbursed through an escrow account. This provides immediate liquidity from an asset no longer aligning with their financial needs.